The Unfettered Pursuit of Happiness

March 2012

March 31, 2012

So here’s a little factoid. I had never heard of William Bengen or the 4% rule before I retired. How could I possibly have calculated whether I had enough money to retire if I had never heard of The Rule?

Well, the spreadsheet that I provided in my last post was the starting point for the spreadsheet that I designed for myself 20 years ago. As I lusted more and more for retirement, I added columns and tweaked the spreadsheet until it became an extremely complicated CPA’s work of art, a lay-person’s nightmare.

First, I separated my asset base between those held in retirement accounts and non-retirement accounts. For my retirement accounts I assumed a higher rate of return than in my taxable accounts, since I would be holding more of my taxable accounts in cash and bonds. (I would need the liquidity in the early years to get me through the first 15 years before I could touch my retirement accounts. I would be much more sensitive to market moves over those years if I were relying heavily on equities in the short-term.) Since the retirement accounts were going to live for 15 more years untouched, and would then be needed to fund the next three decades, I would put the more aggressive portion of my allocation there.

Later, I decided to add a column showing what I thought our Social Security benefits would be if we started taking them at age 70. (I only figured on one-half of the SSA’s benefit statement amount, to be conservative.)

Later on, I tweaked it again to show another column with the decline in expenses after my mortgage was paid off. I incorporated lower tax rates for the early years when my taxable income is low (the income I generate off my assets barely exceeds my itemized deductions.) I increased the tax rate for the years when I would be drawing out of my retirement accounts, as that would shoot me into a higher tax bracket.

I played with the inputs, changing up the growth rates, inflation assumptions, and life expectancy. I was trying to get the spreadsheet to deliver us to age 100, even though it’s unlikely Doug and I will both live to be that old.

After several years watching the spreadsheet only get me as far as 80 or 90, I realized I would be willing to tap into my home equity at that point (or earlier) if I needed to, so I added a column to track the inflation adjusted value of my home in case I wanted to pull some equity out in with a reverse mortgage or by downsizing—varying the amount pulled out to prevent the 100-year old nest egg from turning negative.

I added a column for unusual expenses like a new car a from time to time. I made customization after customization. I played with the spreadsheet more and more frequently as the desire to retire became stronger and stronger. I was determined to figure out ways to make an early retirement work. The spreadsheet is now 12 columns wide after all my special customizations.

Many, many years ago, the retirement spreadsheet said I could retire if I could average 8% returns each year, a few years later, with more saved, it would have worked at 7%. But I didn’t feel comfortable assuming I could achieve either of those. I felt comfortable assuming a 5% rate for my taxable assets (which are less weighted toward equities), and 6.5% for my retirement assets (which hold a higher allocation of equities.) While I am an optimist, before I retired, I wanted to get my assumptions down to a conservative earnings rate, a substantial inflation rate, and a long, long life for both of us. Worst case, we would die with a little money.

When I was ready to leave my job, I felt I had been adequately conservative in my planning. I didn’t ask myself, “How much do I need to retire?” I asked myself, “With what I have accumulated right now, what does the spreadsheet allow my budget to be without turning the last cell negative?” and “Can I be happy living on that?” When the answer was yes, I retired.

A few years ago, I decided to write a post about this whole process. By that time though, I had heard of William Bengen and his findings, so I went back to my original retirement-spreadsheet and laughed. My first year’s budgeted withdrawal rate was 3% of my nest egg, give or take a few 100ths of a percent. So I trashed that post in favor of a post explaining the short-cut. While some might think it was a waste of time to have spent all that time and energy creating my own road map, I felt comforted.

March 28, 2012

Dick and Jane have left the premises because they have better things to do. But Syd is still here and in light of this blog’s spirited discussion of the 4% rule (or 3% rule, whichever applies to you), I wanted to illustrate how distributions work over the lifetime of your retirement when you use the 4% rule.

This particular retiree, Average Joe, actually winds up doing better than the worst-case scenario that drives the 3% rule—the result is that he dies with a little money left over, based on the facts I create. (I could have chosen facts that would result in a better or worse outcome, it doesn’t matter, I’m just trying to illustrate how the withdrawals will work for Joe.)

No one will ever experience a steady growth of exactly the same earnings and inflation rates each year, but I wanted to provide a simple example to show you generally how your retirement withdrawals might look 10, 20, and 30 years down the line when you use the 4% rule:

Joe starts with $1 million. He experiences exactly a 3.5% inflation rate every year of his retirement, and also a steady 5% return every year of his retirement. (Remember the 4% rule is that Joe withdraws 4% of his nest egg in the first year and then adjust that dollar amount by the inflation rate each year. For Joe that’s a 3.5% inflation rate each and every year.) Here’s how his distribution history would look:

*Dollar Amount of first year withdrawal adjusted annually for 3.5% inflation rate.

Here are the two things I'd like to point out:

1) In the early years Joe's assets keep growing from year to year. He begins at $1 million and because his earnings are larger than his withdrawals, his nest egg grows to $1.049 million by Year 9.

2) After that, the inflation adjusted amount of his withdrawals becomes larger than the growth his nest egg generates. Eventually his nest egg declines to $280,000.

3) The percentage of his nest egg (final column) that he is actually drawing each year is only near 4% in the early years. As inflation increases the withdrawal amount it represents a larger and larger share of his nest egg balance. By year 15 he's actually withdrawing over 6% of his nest egg, and by year 25, nearly 13%. If he lives long enough, his final withdrawal would be 100% of his assets and he would die with nothing.

No matter what facts you assume, this will always happen, i.e. that when using a flat starting rate, say 3% or 4%, that you adjust for inflation each year, your nest egg will grow for some period in the early years and shrink after that, down to nothing depending on how long you live.

If you tried to keep your actual withdrawal rate at 4% for a long period of time, you would find that a) you can’t buy as much as you used to, and b) you might actually die with a bunch of with money left over. Which might be ok for those of you with heirs, but I’m trying to bounce that last check.

March 26, 2012

You often see the “3% rule” quoted in retirement literature. Many times it is applied incorrectly, so I’d like to revisit the rule, clear up some misconceptions, and let Dick and Jane show you how it works in their retirements.

Refresher Course

Financial planner William Bengen is responsible for the 3% rule, although that’s not what he called it. Actually it’s the 4.5% rule, but he didn’t call it that either. He called it “Safemax,” and it goes like this:

“If you spend 4.5% of the assets in your tax-deferred accounts in your first year of retirement and increase that annual dollar amount each year by the inflation rate, your nest egg will last at least 30 years under all the historical scenarios tested.”

Bengen realized that relying on the last 80 years’ averages for stocks, bonds, and inflation only helps the hypothetical retiree that actually experiences those exact averages. But what about a retiree in a real 30-year time chunk during that historical period? How would he have fared in the best of times and in the worst of times?

His research showed that a retiree in the worst 30-year time stretch over the 80 years that he studied (which included some whopper recessions and even the Great Depression), would not have run out of money if he withdrew 4.5% of his nest egg the first year of retirement, and then adjusted that dollar amount each year for inflation.

Caveats

-This only held true for retirees that could stomach at least 50% of their portfolios in equities. If you want to do it all on treasuries, the rule does not apply to you. Your money would not have lasted in the worst of times if you were not willing to invest at least 50% in equities.

-In many of the time periods studied, your money would have lasted even longer than 30 years (or put a different way, you could have withdrawn more than 4.5% over those 30-year stretches). The Safemax is purely to figure out what would have been the worst outcome. In the case of the 4.5% rule, the worst outcome would have been that you would be left with no money at the end of 30 years.

-Thirty years isn’t long enough for a healthy retiree wanting to retire in her 40’s or 50’s. That’s why I often quote the 3% rule. It’s just the 4% rule adjusted for the research showing the Safemax for 50 years instead of 30 years.

-The rule does NOT say that you withdraw 3% of your assets each year. That is a common misconception. Read this again: You withdraw 3% of your assets only the first year and then adjust that dollar amount each year for inflation. After the first year, you never again multiply your ending assets by 3% to come up with the withdrawal rate.

Meet Dick and Jane

Dick and Jane are both 50 years old. The year is Year 1, and the S&P index is at 900. Dick and Jane each have identical $1 million portfolios of which 50% is invested a well diversified mix of U. S. large-, mid- and small-cap stock funds as well as international developed- and emerging-market funds. The other 50% is diversified among short-, long- and mid-term bond funds and includes a 3-year supply of living expenses in an FDIC-insured savings account. (As the author of this story, I will not let Dick or Jane invest 100% of their portfolios in the 30 stocks that make up the DJIA. That would be foolish, and as their advisor, I would not let them do something foolish.)

Dick decides to retire right now because his retirement budget is $30,000 and that represents exactly 3% of his next egg. I failed to mention that Dick and Jane live in Podunk, where the cost of living is very low. I also I failed to mention that Dick really hates his job. (And of course Dick doesn’t know this now, but he will live exactly 50 years in retirement, unfortunately dying one day short of his 100th birthday in a tragic bungee jumping accident.)

Jane likes her job ok and wants to stick it out at least for another five years, to hopefully let her portfolio recover from a Big Recession. She retires in Year 5 when the S&P is at 1,400. Now, of course her portfolio is more than the $1 million it was in Year 1, but it is NOT 56% higher as would be indicated by the measure of the S&P index. Only half of her nest egg was even exposed to the stock market, and some of that was in international funds, so her portfolio is 20% higher than it was at Year 1, now at $1.2 million. Dick’s is of course smaller since he has been taking withdrawals from his identical portfolio for five years.

(It might be a good time to tell you that Jane also lives for 50 years in her retirement, dying of natural causes on her 105th birthday.)

Between Year 1 and Year 5 inflation has been 3.5% per year, so while her budget was identical to Dick’s five years ago, $30,000 doesn’t get you what it used to, even in Podunk. Dick is now withdrawing $34.5k (his inflated base amount). Three percent of Jane’s $1.2 million portfolio puts her first year withdrawal Safemax at $36k, which by the way, she really doesn’t need because she already lives on $34.5k—the inflated $30,000. But she has expensive taste in shoes, so she decides to take out the whole $36k maximum.

Now some of you might be thinking, that’s so unfair, why does Jane get to take out more for the rest of her life than Dick does? Just because of the arbitrary place on the S&P (and the affect on her respective portfolio)?

The 3% rule does not say that Dick can’t take out more. Therule just says that if Dick had been unlucky enough to retire during a 50-year period that was as bad as the worst 50 years in recent history, he wouldn’t run out of money. In fact, it’s likely that he didn’t retire in the worst 50-year stretch of history given that the market went up 56% in the first 5 years of his retirement.

In fact, it’s likely that Jane’s 50-year stretch is going to be worse than Dicks, given that Dick already experienced a great 5 years in the beginning of his retirement. The next 45 years, they experience the exact same market together, and then even if Jane experiences a stellar market in her last 5 years of living, it would be on a much smaller asset base by that time. But the rule says that even if she experiences a 50-year stretch as bad as the worst in recent history, she won’t run out of money either.

So what does this rule mean for Dick and Jane? Since Dick and Jane’s retirement overlapped 45 of the same years, and Dick had a stellar first five years in the market, if either of them experienced the worst 50 years, it would have been Jane. If Jane did, indeed experience the worst 50 years, based on Bengen’s research, this means that Jane dies with no money, and Dick dies with some money left. That’s all the rule says.

March 24, 2012

While there was a little more follow-up to this interview for Michael Foster's Bankrate.com article, Early Retirement Without a Fortune, most of that made it to the final piece, so this is the final part I will publish here:

How much did you save to retire? (If you don't want to use actual figures: What is the ratio of your savings to your annual income the year before you retired.)

I've never believed in calculating your retirement nest egg based on a percentage of your annual income, so I won't quote it that way. I projected what I thought my retirement expenses would be (item by item). That exercise worked out to be about 65% of my pre-retirement spending level (not pre-retirement income--I didn't spend all of my income when I was working, so that measure isn't very relevant.) That's turned out to be very accurate, although, we've even spent a little less than that.

My nest egg (both retirement and non-retirement savings) totaled 33 times my projected annual retirement budget. This was my target before I retired, as it would mean that I could withdraw 3% of my nest egg each year and most likely not run out of money before I die. (For those retiring at a more "traditional age", the safest rate could be as high as 4%, requiring a nest egg of 25 times annual expenses.) Those multiples are based on the work of William Bengen and produce a pretty conservative approach. I'm not saying it's the perfect approach but it gives you a ballpark number. I think there are ways to do it on less, but this was just my starting point.

How much do you live on a year? (Again, if you prefer, what percentage of your total net worth do you use to retire?)

I didn't consider my primary residence in the calculations above. Again, I figured at some point I could tap into my equity (either downsizing or a reverse mortgage) but didn't want to count on that. That way I'd have a little extra room for error if things didn't go exactly as planned. So, as a percentage of our net worth, we lived on 3% of our net worth, which excludes the value of our primary residence. That was 3% of our net worth the first year. As you know, the market has gyrated wildly, and is significantly down from when we retired, so as a percentage of our net worth, this figure isn't constant from year to year.

We lived on 3% the first year of retirement, and while we expected to inflate our budget over the last 3 years for inflation, our particular basket of expenses overall has not changed overall, so we're still living on about that same dollar amount so far.

What advice would you give to a would-be retiree?

Retirement is a big adjustment. The first couple years will be surprising as you figure out what you want to be doing with your newfound time. Don't rush it. Try to just see where it takes you rather than forcing a pre-determined idea of what retirement "should be."

As far as financially, I highly recommend having 3 years worth of living expenses available in liquid assets so you don't have to be overly concerned about stock market gyrations. (At least for those of us that will be living on our 401(k)'s rather than a pension.)

March 23, 2012

I know I owe you another post with the last part of my Bankrate.com interview. And I know at least one of you is waiting patiently (or maybe not so patiently) for a post discussing the "3% rule." But I've got too much other stuff to do today, so perhaps tomorrow.

The weather in the San Francisco Bay Area has been so beautiful this winter (and same with spring so far), it's almost like winter just decided to skip us all together this year. Such a contrast to last year at exactly this time of year. This is a picture of our back deck the night of March 17th, one year ago.

March 20, 2012

You guys are all giving me such great ideas in the comments for future posts, but first I will finish my committment to bring you the full text of the interview I did with Michael Foster for Bankrate.com. Here is part two of that interview:

What investments do you rely on the most for your retirement income? (E.g. dividend yielding stocks, company pension, annuity)

So I don't really view my retirement strategy to be based on "retirement income." Rather I plan on drawing on our assets to support us--they generate dividends, capital gains, interest, etc., but we don't use that income to live on. The nest egg goes up and down (mostly from market gyrations), and we take out what we need (that set amount that equaled 3% the first year, adjusted for inflation).

Generally speaking, in the early years, the nest egg would typically be growing faster than the rate of withdrawal, and in the later years, the effects of inflation will reverse that trend, such that in the later years we will be spending down our assets. If all goes well, we'll die before we run out of assets.

I track our progress quarterly, though, so if all seems to not be going well, we will make adjustments down the line (spend less, downsize, reverse mortgage, part-time work, etc. etc.) You have to be flexible when you are living this way, I think.

If your post-retirement income is smaller than your pre-retirement income, how have you adjusted your lifestyle to accommodate this difference?

As I mentioned, we don't really live on the "income" our portfolio generates, rather a set amount of money, which will increase as inflation increases. But since that nest egg is crucial to our plan, and since it dropped significantly our first year of retirement, we are very careful with our spending. We didn't spend much on travel that first year (or other discretionary expenses) while we got a sense of how our financial situation would play out. 30% of our budget is set for discretionary things like travel, eating out, entertainment, recreation, etc. So if an unexpected health insurance premium increase hits without an unexpected decrease in our property tax (both those things occurred in the second year), we just adjust the lifestyle choices within that 30% to make it all work.

If you could go back in time and change anything about your pre-retirement financial strategy, what would it be?

I would have been less aggressive in my stock allocation, probably aiming for a 60% stock/40% cash/bond allocation rather than the 70/30 allocation I retired with. Nothing like a bear market to teach you that lesson!

Just as a side note, I know I say "I" a lot in my answers, but my husband is also retired. He retired about 4 years before I did (we went from being a dual income couple to a single income one at that point--which was a good adjustment to practice before I eventually joined in retirement 4 years later.)

What advice would you give to a would-be retiree?

Retirement is a big adjustment. The first couple years will be surprising as you figure out what you want to be doing with your newfound time. Don't rush it. Try to just see where it takes you rather than forcing a pre-determined idea of what retirement "should be."

As far as financially, I highly recommend having 3 years worth of living expenses available in liquid assets so you don't have to be overly concerned about stock market gyrations. (At least for those of us that will be living on our 401(k)'s rather than a pension.)

Several of the commenters have complained of the article's limited information, for example: Am I married? (Yes.) Do we have kids? (No.) And how much money did I make? (Not gonna tell ya.) Since the article profiled four retirees, I'm sure they had to shave down much of the interview information just to save space. To give you an example, the interview for just my portion is over 1,800 words alone!

But since I've noticed so many additional readers today, I figure many folks do want more information. And since the original interview covered so much more, I thought I'd publish the text of our original (slightly edited) interview, over the course of the next couple of days. Here is the first part:

How old were you when you retired?

I retired when I was 44 years old.

How long have you been retired so far?

Almost 4 years now.

If you have a pension, do you feel that it is enough to fulfill your financial needs?

We don't have a pension. We will both be eligible for Social Security and will probably not draw on that until age 70 so that we can earn the maximum amount. I didn't really consider Social Security in my (retirement) calculations--I thought that would just be an extra safety net. Because each of us worked less than the 30 years needed to earn the maximum benefit--we will not really be entitled to as much as we would have been entitled to if we had kept working.

How would you describe your investment strategy for retirement?

We saved enough in non-retirement assets to cover living expenses until we reach our early 60's and can tap into our retirement assets. We will completely exhaust our non-retirement assets and then switch to IRA withdrawals in our early 60's--adding Social Security in our 70's.

Our asset allocation was 70% stock mutual funds and 30% cash and bond funds at the time of my retirement--a pretty aggressive mix due to my relatively young retirement age. I planned on slowly shifting this allocation away from stocks over the years, but so far, haven't really progressed that direction yet. Since the stock portion of the portfolio has dropped significantly from my March 2008 retirement date, the relative allocation has stayed pretty constant as I draw down on the cash/bond portion to live on.

Is health insurance a problem for you?

Health insurance is very expensive, but I expected that and planned for it in the budget when I retired.

March 09, 2012

Photo Friday The most prolific fruit tree in our garden is a Meyer Lemon. Aside from a twist of the peel for my martini, I'm not sure how to use them all up. Anyone have any good recipes, maybe using the actual inside of the lemon?

(To submit your picture of retirement, email me a photo with how you would like it credited.)